I was recently sent this video clip of Glen Beck on Fox Noise discussing the “Amount of money in circulation” and how this stimulus plan will be devastating to our Children” If you haven’t watched it you can do so at the link below. While I am not a Nobel economist, the following is how I understand the process of Money Creation and it’s effect on inflation.. (This is a first pass but I wanted to get out right away, I will be polishing it on-going) I welcome comments which might better explain this process…

Let’s start in the beginning.. With the passing of the Federal Reserve act in 1916, the way money was created changed forever. It established a system where banks could loan 9 times as much money as they held in assets. Where did this money come from? It was created out of thin air at the moment the loan closed. Over 90% of ALL the money created in this country (and the world) since then, is created this way, and not “Printed” as Mr. Beck erroneously suggests.

You see the U.S. money supply has not been directly proportional to gold holdings since 1916, not 1973 as he suggested.. 1973 was arguably just a ploy to deregulate the value of gold (which had been artificially held at $35.00 / ounce) and it had no real effect on our money supply.. The big jump Mr. Beck tries to associate with Nixon’s taking us off of the gold standard was actually more likely caused by the rampant deficit spending, (to the tune of $500 billion) by the Reagan administration. Of course one can’t expect Fox news to say anything negative about the conservative second coming Ronald Reagan. I am not going to discuss the flaws in the Fractional Banking system, but instead to discuss the issue of inflation within this system.

In the fractional banking system, there is a fundamental difference between Printing money and Loaning money. Both add money to circulation but they are significantly different.

When money is Printed ie paper dollars, Mr. Beck is correct (the only time in this whole video) in saying that this addition of currency to circulation devaluates the dollar.. It is not backed by any tangible asset, just the good faith of the US government. It is suggested that this money is loaned to the US, but that is a complicated issue too much so to discuss here..

When money is Loaned by banks, it is backed by a promise to repay, with money coming from productivity that the loan helped generate. It becomes in effect a promised asset, and creating money this way does not necessarily devaluate the dollar. Over 90% of all money is created this way, and so one can see Mr. Beck’s quaint chart and logic is incorrect propaganda..

The logic behind this system is, that it allows the money supply to expand with the economy naturally, under the assumption that the Lender will insure the borrower can and will repay it. Thus there must be productivity out there somewhere that the borrower will generate, typically through work, that will equal, and repay the loaned money eventually. At that point the created money is backed by productivity and it’s as good as gold. This assumption, however, was the fatal flaw in the recent housing crash, A concise explanation of this process can be found in this post. The creation of loans, ie money cannot be regulated by the market itself without on-going risk of collapse..

So how does this all apply to the Bailout?

The amount of inflation created by stimulus spending really depends on how the “Stimulus” is generated…

Let’s start with the Conservative mantra Tax Cuts. Tax cuts theoretically cause no inflation, a good thing.. But they also cause very little Stimulus, with no more than $1.2 in GDP created per dollar spent, (See Stimulus comparison chart) ie. little of the money given back really get’s spent into the system. Basically, this is because the money is giving to everyone, proportional to taxes paid, with the majority given to more solvent people who will not spend more just because they get a tax cut..

Next, non-infrastructure spending increases..

This type of spending including extended unemployment and increases in food stamps, typically generates more than $1.50 GNP per dollar spent.. This is because this money is given to people who will spend it all immediately because they are financially strapped. In a crisis like this, I think this number could be much higher… THIS type of spending can have no impact on inflation if it is paid through revenues, but if it’s paid with created money, it will devaluate the dollar. But remember, the dollar has devaluated as much as 30% compared to other currencies just based on market perceptions, without any currency increase because ultimately, the currency market is the perfect example of a free market and is driven a great deal by investor perception, and not just hard numbers.. For more on this read George Soros’ wonderful book “A Crisis of Global Capitalism”

Finally, the best form of stimulus… Infrastructure spending..

Infrastructure spending is money loaned against productivity generated, and that productivity effectively backs the money created. Sometimes the project actually generates money to pay the loan back, but this is not necessary to effectively back the money created. These types of spending average OVER $1.5 in GDP per dollar spent AND they give something in return… namely INFRASTRUCTURE. But as I have out lined in my letter to President Obama entitled “What to do” , it appears to me (and Thomas Friedman) that the best return on infrastructure spending comes not from repairing 20th century infrastructure, but instead from investing in 21st century infrastructure that can make the US more competitive in the global market and bring jobs HOME..

Hi Eric,
A very good article. There is much confusion when it comes to the monetary system, and many things being talked about which are simply not correct. You pointed out a few of them.

The fractional reserve system in use today is a very big topic, and the issue is not one sided.

But first a little history is helpful. The origin of the fractional reserve type system came originally from European Goldsmiths who would eventually evolve into the bankers of today. They were private individuals who had nothing to do with government. And as you might imagine money was at one time based on Gold. As they began renting out space for people to store their gold, they began issuing paper receipts or certificates which were much more convenient for folks to carry around, and this was the birth of what would become modern paper money.

The early bankers also realized that they could loan their own gold out at interest to make a profit. Seeing an opportunity for increased profits, they also began loaning out the gold which was not theirs, but the property of those holding the certificates.
They figured as long as they had enough on hand to satisfy the daily exchanges of their customers, they would be okay. This was the birth of the fractional system, meaning that they had on hand a fraction of what they had loaned out.

Their biggest profit came from the collection of interest a practice known as usury. Meaning charging some one a fee for the use of the money.

So one thing which you cleared up is that the issue of the gold standard and the issue of fractional reserve banking is not directly connected, and in all the debates, these separate issues are often mixed together.

Another thing which you pointed out was that the majority of money does not exist as paper, but as leger entries, which are now days entirely electronic. But in practical and actual terms, the inflationary nature of increasing the money supply is valid whether you are talking paper money or electronic money. An increase in the supply, without an increase of goods or services within the economy will reduce the buying power of the currency ie. Debase the currency. The term debase actually come from what happened in the Roman Empire when Rome was trying to finance its empire expansion through military force and found themselves without enough coins to pay the soldiers. So they started to mint coins which were not made of pure gold, but instead added base metals (debasement). This increased the supply, but the value of the coins themselves was increasingly diminished.

It was one of the factors which lead to the collapse of the Roman Empire. Returning to our present day system, and setting politics aside for the moment, economically the debasement of the currency is not a good idea. In Rome, if you had some gold coins stored away, and the government issued new coins containing less gold, you savings were not affected as the amount of gold in your coins was not affected, by the new money. But in our present day system, the buying power of all the currency is diminished by the addition of new money, regardless of whether it is paper or electronic.

Another thing which you pointed out which correct is that the loans or credit issued by the banks today is not making money out of thin air as so many claim. It is trading credit for a promise of payback which is a promise of labor, or entrepreneurial future anticipated profits by the borrower.

Yes, a gold coin was worth what it was worth, until of course the spanish found the gold in South America and crashed their own currency..

The gold standard DIDN’t work. There were LOTS of crashes just like this one, most recently in 1873 AND 1929.

While paying interest to teh Fed does not make sense, the fractional banking system actually does. I once absolutely believed the FEd was the root of all evil, and while I believe they are corrupt, I now undertsand the need for a dynamic productivity backed currency. While the money is worth 5% of what is was in 1900, the wages are 20 times higher.

There has been inflation but that is mostly due to the competition from abroad. It’s hard to preserve our lifestyles with so many out there willing to do the same work for 1/3 as much. That is what is destroying our buying power. Our inability to compete globally. You have to look at the MACRO system, and stop being fixated on this Rand nonsense. If nothing did before, this crash proved Rand was full of shit… There are lots of things that have to change including the fed, but I have come to the awareness that Debt creation system of currency actually works, with some drastic changes. It has been allowed to be rpedatory and purely favoring the rich and that has to change. But the basic system does not and will not. It is the international standard. It’s over, done, it will never go back. We must make it work. But the free market does not work as it stands… In the big casino, the house always wins… read my post on “a bold new plan…”

[…] seem to find much info that argues against this, intelligently. Anyone? The best I could find: Glen Becks segment “Inconvenient Debt” explained for the propaganda it is… Where C… And I still don’t really get it. Then again, I suck at anything having to do with economics. […]